Pizzas and Value Investing

Here is some myth-busting about stocks. During the process I’ll end up explaining “value investing”—a method of investing applied by many great investors including the legendary Warren Buffett.

Pizzas are great gurus. We will take help from pizzas whenever things get complicated.

Before we start, be aware of this: A stock (or ‘share’ as it is alternatively called) is a piece of a business. If Reliance Industries is a pizza, a share of Reliance Industries is a slice of the pizza, albeit a very small one.

Here we go.

Myth: Price of the stock indicates size of the company

A large pizza can be cut into many small pieces. The size of the slice does not indicate the size of the pizza.

Exactly the same for the businesses. The price of one share does not tell anything about the size of the company.

As I’m writing this, ITC’s stock is trading at Rs. 260, and MRF at Rs. 72,000. But ITC is a 10 times bigger company than MRF. That’s because ITC has 12,300 million (1230 crore) shares, whereas MRF has only 4.2 million (42 lakh).

That means the total price of all the ITC shares put together is Rs. 3,20,000 crore, as against MRF’s Rs. 30,000 crore. This total price of all shares put together is called “Market Capitalisation” and it indicates the size of the company.

MRF is a smaller pizza with fewer slices. ITC is a bigger pizza with a lot more but smaller slices. Looking at slices, you misinterpret the sizes of the pizzas.

That takes us to the next myth.

Myth: 20-rupee stock is cheap and 20,000-rupee stock is expensive

If a slice of one pizza costs less than a slice of another pizza, can you tell which pizza is expensive? No, unless you know the size of each slice.

The same goes for the businesses. By knowing the price of one share, you cannot comment whether it is expensive or cheap. Unless you have an idea about the “size”.

You can’t say that ITC stock is cheap and MRF stock is expensive only from their prices.

Since the price of one share doesn’t indicate anything of significance, you can conclude that everything else being the same, the probability of a 20-rupee stock and a 20,000-rupee stock going to zero is the same. The probability of their doubling is also the same. How much you earn or lose from a stock is a function of percentages and not absolute prices.

So, what is an expensive stock and what is a cheap stock? For that, we need to understand valuation. That’s next.

Myth: 10 P/E is cheap, 40 P/E is expensive

As against the widely held belief, Price to Earnings ratio (P/E) cannot say whether a stock is cheap or expensive. In fact, no ratios (P/B, DY, etc.) can tell you that.

At 800 Rs./kg, almonds are cheap. At 250 Rs./kg, rice is expensive. The ratio “price/weight” does not tell you whether the product is cheap or expensive. The ratios “Price/earnings” or “Price/Book Value” etc. does not tell you whether the stock is cheap or expensive.

So, what is “cheap” or “expensive”?

To know if something is cheap or expensive, you first need to know its “worth” or “value” and compare it with its price. If the “price” is less than the “value”, the thing is cheap—whether socks or stocks. The thing is expensive if the reverse is true.

How do you know the “value” of a pizza? It depends on its size, the toppings, the crust, the ambience of the restaurant, the art of the chef, your personal preferences, etc.

Value of a pizza—like everything else—is different for everyone. And it also cannot be a fixed number but an approximate range.

Don’t you find it crazy when your spouse chooses a cheese-burst over a pan pizza? For her/him, the former has more “value” than the latter. For you, it’s the opposite.

How to know the “value” or “worth” of a business?

What is true for the pizzas, is true for the stocks. “Value” of a stock is different for everyone. And it also cannot be a fixed number but an approximate range.

But unlike pizzas, here we have an underlying principle about what is the value of a company: the value of a business is the Net Present Value of its future cashflows.

In common language, if all the money that a company is going to earn in the future is totalled, and is adjusted to its present value (keeping in mind the future interest rates and risks), you get the company’s “worth” or “value”. If you divide the company’s value by its number of shares, you get the value of a share.

But here lies the problem. You cannot know the exact amounts a company is going to earn in the future. (Sure, you can make Excel sheets like the MBAs do, but the future is under no obligation to stick to your Excel sheets—No offence intended; I’m an MBA.)

What you can do is have educated expectations, which will be different for everyone. And since our expectations keep changing as the world around us changes, the valuation keeps changing.

At any given point in time, the price of a stock indicates the market's estimated “value” of the company based on the market's expectations of all the future earnings of the company.

If your expectations from a given company are higher than that of the market's expectations, the stock is cheap for you; and vice-versa.

That brings us to the insight:

Value Investing and how the fortunes are made in the stock market:

To summarise, this is value investing: Estimate the “value” of a stock, and compare it with its price. Buy the stock if the price is much lower than the value. Milk the returns when the price rises as the market understands the true value of the stock.

The trick is in knowing with conviction that a company expected to be a mediocre by the market is going to be a superstar.

Fortunes are made when the market disagrees with you today and agrees with you a decade later. That is difficult to achieve because you are also a part of the market.

Let’s bust one more myth before we finish.

Myth: Past stock price is an indication that the stock can rise

People somehow have strong attachment with past peaks of a few stocks. One example is Suzlon.

Many believe that Suzlon share—presently trading at Rs. 9—is worth much more just because it used to trade above 300 rupees years ago. That’s illogical because the past stock price is not going to affect the future earnings of the company in any way.

Things were rosy for Suzlon in 2007. And therefore, its expected future earnings at that time were quite large. Hence, the price was high. But then the facts changed and so did the expectations. The future earnings expected from Suzlon today are quite low—possibly negative. And therefore, the low stock price is justified.

But that’s not to say that Suzlon cannot flourish in the future. It can, but that is not “expected” by the market today.

Thanks for reading. Good day, pizza lovers!